The Challenge of Being a Passive Investor
- Investors face the prospect of poor expected long-term returns making buying and holding less desirable for both equity and bond holders
- Given that bond yields are so low, investors are being forced to hold risky assets such as equities to earn sufficient returns. This forces passive investors to have to tolerate substantial volatility.
- Passive investing is more suitable for younger investors that contribute regularly since they dollar cost average over time which mathematically benefits from higher volatility. The reverse is true for investors in retirement that withdraw regularly over time and therefore their portfolios mathematically suffer from higher volatility.
- Passive investing is also psychologically unrealistic for “average investors” which is supported by evidence that they constantly underperform their comparable passive benchmarks by a significant margin.
Is there a better solution?
- Dynamic or tactical asset allocation strategies are some of the most effective forms of active management. They are especially useful to investors in retirement because they implicitly have a systematic methodology for managing risk.
- The primary purpose of these methods is to shift the efficient frontier to lower portfolio risk for the same level of return as a comparable passive approach.
Dynamic or tactical asset allocation has four potential benefits for investors in retirement:
- it can make the ride a lot more comfortable, thus preventing poor decision-making;
- it can reduce the risk of ruin
- it can increase the sustainable withdrawal rate
- it can boost returns and hence increase the final value of your portfolio
We compared several conventional passive strategies versus a number of different popular dynamic or tactical asset allocation approaches for investors in retirement. Using mathematical simulation we investigate whether dynamic or tactical asset allocation offers superior benefits to investors in retirement than a conventional passive approach.
Results of the Study
- The results show that the average active strategy has more than 3x the Gain to Pain Ratio (sustainable withdrawal rate/maximum drawdown) as the average passive strategy. Active strategies such as dynamic/tactical asset allocation have offered retirees a superior trade-off in terms of the level of sustainable income versus their expected maximum risk or worst case scenario.
- The results show that the average active strategy has less than half the risk of ruin or odds of running out of money as the average passive strategy. In other words, active strategies can help retirees reduce the risk of running out of money versus employing a passive strategy
- The results show that the average active strategy has more than double the sustainable withdrawal rate as the average passive strategy